A bull in the China shop?

The Chinese stock market has been making some upward progress this year after the dramatic boom and bust cycle it went through in 2015. The authorities had a plan to involve more Chinese people in the stock market, and to gradually open Chinese shares to more foreign capital and influence. Unfortunately for them, individual investors and brokers took to the idea in a rush, and bid the market up to very high levels on borrowed money. When the authorities sought to rein in the excess, they found it difficult to stop a plunge in values and a dramatic loss of confidence by domestic shareholders. Around the same time they had to manage the transition of their currency from a link to the dollar to a link to a wider basket of currencies, to meet IMF requirements.

It drew attention to a problem of the Chinese model. Growing a larger service sector and encouraging much freer financial markets may result in outcomes that are too volatile and difficult for the government to accept. In a country where the government is used to being in charge, adapting to wild swings in popular emotions on the outlook for shares and the economy is difficult. The government is seeking to liberalise investment and money flows with the rest of the world. It has set up the connectors between Hong Kong, Shanghai and Shenzen to encourage two-way trading in Chinese shares. It has gained admission for the renminbi in the SDR, and is now issuing SDR bonds in China and renminbi bonds in London. It needs to avoid excessive movements in its currency.

The Chinese, however, still have a large nationalised banking sector. The authorities exert considerable control over their banks and the wider financial system generally. They have recently signalled they are concerned about a bond bubble, and have reined in very cheap seven-day credit for banks as a result. They are regularly seeking better ways to control the less regulated companies which spring up to get round the financial and credit controls on banks. Whilst Chinese state debt remains under very good control, private sector debt in China and local government debt is high. China does not grow so quickly for any given addition of debt in the way it used to. Large amounts of debt have been used to build capacity in industry that is now no longer needed.

The magnitude of the task to change the emphasis of the Chinese model from investment, industry and exports, to consumption, services and domestic activity is huge.

The magnitude of the task to change the emphasis of the Chinese model from investment, industry and exports, to consumption, services and domestic activity is huge. China reckons it has 100 million tonnes of steel capacity excess to its needs. It thinks it has 500 million tonnes of coal mining capacity that needs to close. By 2020 the government anticipates losing 1.8 million jobs in the coal and steel industries alone. There are various other industries with similarly large world market share and excess capacity. China has to find a way of retraining and employing people as these jobs go, and has to handle the write off of capital as the closure programmes proceed. China’s critics in the US and elsewhere express concern about the impact of the closures and write offs on the banks and debt markets. The Chinese leadership doubtless also worries about the social consequences and the impact on cities that depend on core industries. To date, the government has handled this new direction well, but the more troublesome closures lie ahead.

There are also difficulties in building the modern digital economy given China’s social and political model. The success of economies like the US and UK rest much on innovation. They depend on free-wheeling talent, which can use the new internet and digital world to buy and sell knowledge, entertainment and services. This is tricky to combine with a wish to avoid dissent or ideas that the government finds inconvenient. The Chinese did not pretend to drop their President by parachute to open their Olympics, and certainly did not employ a Mr Bean to send the whole thing up in the middle of the ceremony. The UK did, because an open society can accept self-deprecation and can extend its brands by playing with them. In a world of competition for popular brands, a top down controlled model has its limitations.

There is more of a sense that the Chinese administration wishes to go back to controls, than in their first year or two in office. They are pushing hard in the seas of Asia to extend their reach by reclaiming land for new islands, and imposing their presence in the Spratty group of islands and the Paracel islands. There are diplomatic incidents with Brunei, Malaysia, Japan, Viet Nam and the Philippines as a result. At stake are economic interests in fish, oil and gas reserves and the shipping lanes, as well as the question of political control and the projection of power. It looks as if China is now encountering more resistance in the West as well. In the USA there is antagonism to China’s trading model, and court action about intellectual property. In the UK the new government has decided to review the commercial and security logic of Hinkley Point nuclear station and any subsequent nuclear stations.

China did fantastically well to grow at more than 10% per annum and to come to dominate many markets for manufactures. The next stage of her journey to mature economy and world power is proving more complex. The government needs to find a new balance between the freedom needed to release enterprise and economic success with the leadership it thinks it needs to give to keep the country united. More difficult still, it needs to find the right pace of winding back the big over-investments of the past, and the best way of transferring people into new service sector activities that require a more individualistic and open mindset. The Chinese stock market has now reached a more sensible valuation after last year’s excessive moves in both directions, and no longer looks cheap.

The above article by John Redwood, Charles Stanley’s Chief Global Strategist, was first published by Charles Stanley on 30th August 2016.

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